Tough Times for TIPS

June 20, 2013 | Mike Spychalski, CAIA, Vice President

This week’s Chart of the Week illustrates the significant increase in yields on the 10 Year Treasury Inflation Protected Security (TIPS) over the past several weeks. From May 1, 2013 to June 19, 2013, the yield on 10 Year TIPS increased from -0.67% to +0.26% (an increase of 0.93%). Over that time frame, investors holding 10 Year TIPS contracts suffered losses of approximately 8.0% (there is an inverse relationship between prices and yields, so as yields increase, prices fall). This huge selloff in TIPS has largely been driven by the increase in yields on the 10 Year Nominal Treasury, which saw yields jump by 0.72% over the same time period (representing a loss of 4.9%). Much of the increase in the 10 Year Nominal Treasury yield has been attributed to expectations that the Federal Reserve Bank, which is currently purchasing $85 billion worth of Treasuries and Mortgage Backed Securities every month as part of its various quantitative easing programs, is going to start winding down its asset purchases in the near future. This was confirmed on June 19, when Federal Reserve Chairman Ben Bernanke announced that if economic data continues to come in line with the Fed’s current expectations, the Fed will begin to scale back the level of asset purchases later this year, and could end the asset purchases entirely by mid-year 2014.

However, the jump in nominal Treasury yields does not fully explain the recent increase in TIPS yields. The yields on TIPS are driven by two primary forces, nominal Treasury yields, and inflationary expectations. Thus, the increase in TIPS yields that is not explained by the increase in nominal Treasury yields is primarily attributable to falling inflationary expectations. This should not be surprising given that one of the primary goals of the Fed’s quantitative easing programs was to prevent deflation from occurring in the U.S. economy (i.e. increasing inflation). The simultaneous combination of higher nominal Treasury yields and falling inflationary expectations are the perfect storm that led to the significant losses in TIPS over the past several weeks.